Diversification and P2P Lending – Part 1

Being diversified across many loans is one of the keys to having a successful experience when investing in p2p lending. As with other investments, diversification will reduce the chances of your investment returns experiencing volatility.

Both Prosper and Lending Club provide statistics on owning at least 100 loans. This equates to a total investment of $2,500 investment across 100 loans ($25 per loan) and should be the bare minimum to start with when opening a Lending Club or Prosper account. Certainly adding more notes would be a wise decision as we will explore in this post and our second, more in depth post on this topic.

Below is Lending Club’s guide on diversification. Note that that the percent of investors who earn a negative adjusted net annualized return decreases significantly when you own at least 100 notes and no one loan accounts for greater than 1% of your total portfolio. It is important that if you are purchasing just 100 loans, that the investment in each loan is the minimum amount allowed of $25.

The below graph from Lending Club shows the extreme volatility with portfolios under 100 loans. At the 100 loan mark, even though returns may still be more likely to be positive, there is a wide range possible. Around the 200 loan mark, volatility begins to taper off substantially and offers the much more consistent returns that seasoned investors are used to.

Prosper, similar to Lending Club advertises that 100 loans is the minimum amount of loans you should own when investing. However, they claim that 100% of investors that own 100 or more notes are achieving positive returns.

Can I be too diversified?

In general, having more loans will not affect your performance. Just take a look at the chart from Lending Club above. You don’t see much benefit from diversifying beyond around 500 loans, but even at 1,500 loans you are not hurting your performance.

The exception is if you have strict criteria for loans that you believe may out-perform the averages. In this case, if you are loosening your criteria in order to be fully invested, there is a chance that your returns may be affected. Given the robust volume of notes that Lending Club is originating, it is unlikely that any but the extremely large investors would run into this issue.

Learn More on Diversification

The main issue with this analysis from Lending Club is the fact that it is based on historical information, which does not include a probable increase in defaults during a recession. It is possible that during a recession that a 100 note portfolio will perform far worse than accounts that own several hundred or even thousands of notes. In part 2 of our discussion on diversification, the Chief Credit Officer of NSR Invest will shed some light on how many notes you should own for full diversification given different assumptions and economic environments.

I don’t believe one can over diversify. Take the example of a casino (which for all practical purposes always has the “edge”). Does a casino want bettors to make few large bets, or many small bets. Clearly the casino wants the bettor to make many small bets to put their “edge” to work. The more bets that are made, the more certain the casino will win. Similarly, if I have an edge in selecting loans then the more loans in which I invest, the more likely it is that I will realize my edge. The common wisdom is that after a certain number of loans the benefits of further diversification becomes moot. Mathematically there is no question that the benefit of each additional loan is less, but if you can find loans that satisfy the criteria that produce your edge you should invest in them to increase your confidence that you will realize your edge. Otherwise you may simply be unlucky.

This isn’t a casino. We don’t have unlimited “edges”. If markets were a casino (jokes aside), then I could buy little bits of lots of things to generate alpha according to your comparison. But that doesn’t generate alpha, it generates a market portfolio that performs exactly as the market.

You are only diversifying by your edges, which inherently limits your ability to diversify. To continue to diversify means the pool has to get bigger or your standards have to ease up. And LC will continue to try to reduce the pool of mispriced loans, so that’s not working in our favor.

IIRC, you can clearly see this from the ANAR chart. Change the number of notes upward. Yes the volatility declines, but the number of “star” portfolios above everyone else also declines. Just the way things work

Actually I agree with almost everything you’ve said, but I still really like my casino analogy. Given the size of my portfolio I have been able to stay fully invested in a large number of notes (now about 4600 active and current) of a small value each ($25’s and $50’s) that meet my criteria to (arguably) produce an edge over a randomly selected basket of the same number of notes with the same same average age and weighted interest. I’ve relied on P2P Picks PMax LC Grade E & E selections to provide the alpha (if one exists), and my own auto-invest software to purchase the notes. To stay fully invested over the past two years I have had to loosen my criteria from PMax 5% & 10% only to PMax 5%, 10% and 25%, and increase my note size from $25 to $50. Yes, no doubt LC’s pricing probably gets better every day so “the times they are are a’changin”.

Put simply, the more notes I own that meet my selection criteria the less luck plays a part in my ANAR. My goal is to minimize luck so that it does not overwhelm the small alpha (edge) that is (again arguably) produced by my (Bryce’s) selection criteria. IMHO a small alpha is hard to find and 100 or so bps is huge. I am required to own LOTS of notes to be confident it is not overwhelmed by bad luck. There is no such thing as too many notes if they all meet my selection criteria. If you own lots of notes and your selection method is no better than random you will still get market average performance (and not be punished for bad luck). If your selection method produces negative alpha, well …

Given the same average interest rate and age I am not jealous of the star portfolios with fewer notes (they are lucky) and shouldn’t feel bad for the significant under performers (they are unlucky).

Ryan your advice proves valid in 2018 just like it did in 2015. P2P has become popular in New Zealand but we’re a small country and platforms are limited in number as the industry has consolidated. Harmoney is our biggest and they recommend your practice – they’d also limited a loan to a $25 exposure. Thanks for asking the question “can I be too diversified” – if the risk profile represents the total market, then the answer I think is no.

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